Commentary: Unless Iran backs off, the war premium will remain

GaryDorsch

NEW YORK (MarketWatch) -- Crude oil has entered into uncharted territory, with prices climbing above psychological barriers, such as $50, $60, and $70 per barrel, then establishing these levels as a base of support, before mounting rallies into still higher ground.

Markets don't trade in a straight line, they usually move up and down within a trend. Crude oil has been marching higher in an orderly fashion since the U.S. conquest of Iraq, fueled by a razor thin difference between global supply and demand.

The uptrend in crude oil has confounded market bears, because prices were climbing alongside a 25% increase in U.S. commercial oil stocks from two years, to an eight-year high of 347 million barrels in June. Apparently, U.S. oil companies have been hoarding oil supplies, in case Iran decides to withhold crude oil exports or targets oil tankers in the Persian Gulf. Iraq is also falling into a civil war and its daily oil output of 2.4 million bpd is unstable. And now China has just completed oil storage tanks in Zhejiang, Shandong and Liaoning, with capacity to hold up to 88 million barrels, and is planning a third phase of yet another 200 million barrels of storage.

There is also growing demand for crude oil in China and India that keeps oil prices bubbling. China's crude oil imports for the first five months of 2006 were up 17.9% at 12.4 million tons. The country imports more than 40% of its crude. India's oil imports rose to 9 million tons, 12% higher from a year ago, and its industrial production was up 10% in May from a year earlier, bolstering its oil demand.

These two emerging giants contain a third of the world's population, and future demand from China and India might exceed the world's spare capacity in a few more years. Chinese oil imports have climbed from 4.8 million tons per month in late 2002 to 12.3 million tons in June 2006, a whopping 156% increase. World oil demand should soar 37% from this year's almost 86 million barrels per day to 118 million bpd by 2030, the U.S. Energy Information Agency predicted on June 20th, led by China, India, and the U.S.

A favorite Iranian tactic

Iran is OPEC's second largest oil producer, and exports about 2.4 million barrels per day. Iranian leaders know how to rattle the nerves of crude oil traders by threatening to shut down the Strait of Hormuz. Iran's president, Mahmoud Ahmadinejad, has frequently called for the destruction of Israel. In the latest flare-up of violence in the Middle East, Hezbollah and Hamas are doing the fighting against Israel, but Damascus and Tehran are pulling their strings.

The major wildcard in the Middle East depends on whether Tehran decides to take a chance and authorizes Hezbollah to launch long-range missiles with more powerful warheads at Israeli cities. It is difficult to assess what the Iranian leadership will decide next in its war to "wipe Israel off the map." But if Hezbollah strikes Jerusalem or Tel-Aviv, it could spark a wider war between Israel and Syria, and Iran has vowed to join the battle, if Syria is attacked.

Last week, schizophrenic crude oil traders concluded that the fighting between Israel and Hezbollah would not widen to the Iranian-Syrian axis. Hindsight is the best sight, but Iranian "War Premium," for crude oil began to unwind on July 17th, just one day after the Tel-Aviv 25 stock index (1884418) put in a stunning reversal bottom at the 720 level, before rebounding 8% off its low of the day.

The reversal bottom in Tel-Aviv blue-chip stocks and the Israeli shekel's rebound against the U.S. dollar, were ruling out a wider Mid-East war for now, which contributed to a 10% drop in U.S. crude oil prices. However, although the tension level has been lowered, Hezbollah's attacks might just be a sneak preview of the damage that Tehran can inflict on Israel and the global stock markets, if the United States decides to push tough economic sanctions against Iran.

Despite being the world's fourth biggest crude exporter, Iran is heavily dependent on gasoline imports because of its lack of refining capacity and buys 440,000 bpd of gasoline from abroad, or more than 40% of its daily consumption. Tehran could prove highly vulnerable to international sanctions on its gasoline imports. Iran's gasoline imports are supplied by Swiss-based trader Vitol and India's Reliance. Washington could go further with a naval blockade of Iran, halting its $54 billion per year of oil exports, or 90% of the Ayatollah's income.

Iranian blockade?

The Saudi Arabia royal family has openly condemned Hezbollah's war on Israel, worried about growing Iranian Shiite influence over the region. Saudi Arabia's All-share index has tumbled about 50% since reaching an all-time high in February. The criticism comes, not out of love for the Jewish state, but instead out of a recognition of the katyusha rocket attacks as the opening salvo in Iran's war to "wipe Israel off the map" that could eventually spread to the Persian Gulf.

So far, the U.S. has defended Israel's air and sea blockade of Lebanon, to block the delivery of ammunition to Hezbollah, and to also gauge the local Lebanese attitude for removing Hezbollah from their midst.

Would the U.S. initiate a unilateral blockade of Iranian oil exports, recognizing that China and Russia would never agree to U.N. sanctions against the Ayatollah? The loss of Iran's 2.4 million bpd of oil exports could be mostly made up by Saudi Arabia's 2 million bpd of spare capacity. In addition, member states of the OECD, have oil reserves of about 4 billion barrels, enough to cover the Iranian shortfall for several years. And without its $54 billion of annual oil sales, Iran's economy could collapse, leading to massive unemployment, and a toppling the Ayatollah's regime.

Under this scenario, the world might have to live with $80-plus per barrel for crude oil. But Tehran won't take an oil embargo lightly, and would try to disrupt the flow of oil through the Strait of Hormuz, or 17 million barrels per day, to drive world oil prices to $100 per barrel or higher. Without credible economic sanctions against Iran though, the alternative is a military strike against its nuclear facilities, or a nuclear armed Iran. There just are no good alternatives, which is why crude oil should continue to command a $10 to $15 per barrel "war premium."

The last time the crude oil market built in a $10 to $15 per barrel 'war premium" was from November 2002 through early March 2003, as the drum beat of war with Saddam Hussein's regime grew louder. Yet at the moment U.S. president George Bush presented Saddam with an ultimatum of war or exile on March 19th, the price of crude oil peaked, and began to collapse by 25% within a few days, even before the first bombs fell in Baghdad. Oil traders had correctly calculated that the war would end quickly, and without any damage to Iraq's oil installations.

There is always a risk that the current $10 to $15 per barrel "war premium" built into oil prices, due to fears of an eventual military confrontation with Iran, could dissipate overnight, if the Ayatollah flinches at the eleventh hour and agrees to the U.N. incentive plan for abandoning the enrichment of uranium. But Iran is not Iraq, and the game of brinksmanship between the U.S. and Iran, probably won't be settled until after the U.S. Congressional elections in early November.

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.